Did "Smart Guys" Destroy Wall Street?

October 14, 2009

I think Calvin Trillin--or at least his bar-room companion--is really on to something here:

“The financial system nearly collapsed,” he said, “because smart guys had started working on Wall Street.” ...

I reflected on my own college class, of roughly the same era. The top student had been appointed a federal appeals court judge — earning, by Wall Street standards, tip money. A lot of the people with similarly impressive academic records became professors. I could picture the future titans of Wall Street dozing in the back rows of some gut course like Geology 101, popularly known as Rocks for Jocks. ...

“Two things happened. One is that the amount of money that could be made on Wall Street with hedge fund and private equity operations became just mind-blowing. At the same time, college was getting so expensive that people from reasonably prosperous families were graduating with huge debts. So even the smart guys went to Wall Street, maybe telling themselves that in a few years they’d have so much money they could then become professors or legal-services lawyers or whatever they’d wanted to be in the first place. That’s when you started reading stories about the percentage of the graduating class of Harvard College who planned to go into the financial industry or go to business school so they could then go into the financial industry. That’s when you started reading about these geniuses from M.I.T. and Caltech who instead of going to graduate school in physics went to Wall Street to calculate arbitrage odds.”

I'd put it just slightly differently (and I realize Trillin is only about three-quarters serious): The key change on Wall Street was more sociological than intellectual. That is, it wasn't so much that the smart guys went to Wall Street--though the intellectual caliber of the financial sector certainly increased with all those quants running around. The relevant change was that a lot of "outsiders" suddenly came to Wall Street, which had previously been dominated by insiders.

Until about the 1970s, the firms that held most of the power on Wall Street were establishment institutions. The downside of this is that Wall Street tended to be inbred, clique-ish, unimaginative, inefficient, intellectually flabby, self-satisfied, and effete. (This was largely the three-martini-lunch crowd that had gone to elite schools and whose fathers and grandfathers had held more or less the same jobs.) The upside was that it was inbred, clique-ish, unimaginative, inefficient, intellectually flabby, self-satisfied, and effete. Which is to say, the global economy wasn't exactly at risk of being super-charged by these guys. But neither were they going to flame out spectacularly.

But, during the seventies, the power on Wall Street started to shift to the outsiders. Some of this was the rising prominence of non-traditional, non-WASP (some would say blue-collar) firms on Wall Street, which various structural changes in the industry, like the end of fixed commissions, were suddenly empowering. (Think Salomon Brothers and Drexel Burnham.) Some of it had to do with the rise of proprietary trading desks at more traditional firms (rather than old, white-shoe "relationship" banking), which the same structural changes were propelling forward. (The trading desks had traditionally been a bit marginalized and declasse--populated by white ethnics from no-name schools.) And some of it had to do with the kinds of people--again, usually white ethnics--who were starting to graduate from elite universities as those schools became more meritocratic. The same old firms may have recruited from the same old schools, but those schools were beginning to produce a new type of graduate.

Anyway, the thing about upwardly-mobile outsiders is that, in addition to being smart and creative, they tend to be incredibly hungry. The establishment had its own set of unwritten rules--defenders would call them "norms," critics would call them "prejudices." Almost by definition, the outsiders didn't abide by these rules, since one of the rules was that outsiders should be excluded. So you got people like Michael Milken and Saul Steinberg and Lew Glucksman and Sandy Weill suddenly doing incredibly aggressive, entrepreneurial things that the establishment had never contemplated. All the things that "just weren't done" these people did, and a lot of them were a net plus for the economy. For example, before Milken and Drexel, there wasn't really a market for junk bonds because the establishment investment banks would snub unpedigreed companies whose debt was relatively risky. By creating such a market, Milken helped channel credit to productive enterprises that otherwise had limited access to it.

But the problem with people bent on doing things that "just aren't done" is that there's a subset of things they really shouldn't do. So overseeing the financial sector becomes a lot trickier. Under the old order, there were individual acts of malfeasance, but firms weren't systematically pushing the boundaries. The new order was all about pushing boundaries, which required regulators and politicians to know which boundaries should persist and which shouldn't. Unfortunately, this happened at a time--the Reagan revolution, later the GOP Congress and the George W. Bush era, with the Greenspan Fed spanning a lot of those years--when government wasn't much interested in policing boundaries. Ergo, credit default swaps. (I'm obviously overstating here, but you get the idea.)

So the moral of the story is twofold: 1.) The government obviously needs to get better at this policing business. 2.) We need to realize that, while there were real advantages to having creative, entrepreneurial people descend on Wall Street, there's a lot to be said for laziness and self-satisfaction in this particular sector (especially in overgrown banks).

Update: In case it's not obvious, what I'm not saying here is that "the Jews destroyed Wall Street." And, believe me, I'm inclined by sociology, temperament, and experience to root for the outsiders in most situations. (Heck, I was even rooting for Milken through about the first half of Predator's Ball.) All I'm saying is that, whereas I consider a disposition toward boundary-pushing a good thing in almost every aspect of life, it's become clear that it can have enormous soccial costs in the financial sector.

Update II: A colleague complains that my logic here is still a little muddled, so let me try again: I think people are too focused on ethnicity, which is my fault since I introduced it. The point isn't that there was something about Jews or various white ethnics that led to excesses on Wall Street. It was the shift from a closed, establishment-dominated financial sector to an open, competitive, meritocratic financial sector that created lots of benefits (like junk bonds), but also certain excesses. It just so happens that the Jews and white ethnics had been largely excluded during the establishment days. So the transition from closed to open coincided with a lot of non-WASPs descending on Wall Street. But the story isn't ethnicity; it's the competition. Ethnicity is an effect, not a cause.